Time for a Smaller and Stronger Eurozone

The euro is central to Europe's economic prosperity, financial stability and political harmony. Moreover, given America's own set of economic challenges, a well-anchored euro is critical to placing an increasingly multi-polar world economy back on the path of high growth and job creation.

The euro should, indeed must, be saved. And it can be saved provided Europe is willing to make hard structural and institutional decisions.

Difficult choices are often avoided in favor of the "status quo." This tends to be the path of least resistance. But there is no status quo in today's Europe. Absent a change in approach, the crisis will continue to spread, fragmentation pressure will mount and the Euro will be even more vulnerable to policy mistakes and market accidents.

The time has come for the eurozone -- Germany and France in particular, but also Austria, Finland and the Netherlands -- to decide how they would like European integration to evolve; and they need to do so quickly. They have two conceptual choices: restore stability to the current, heterogeneous zone; or opt for a smaller but stronger one.

Neither option is easy, and both are very controversial. They involve substantial upfront costs and high likelihood of collateral damage and unintended consequences. Also, with implementation fraught with risks, they require an unsettling level of policy experimentation, innovation and responsiveness.

Yet both options dominate the path currently pursued by Europe which, distressingly, involves a growing threat of an uncontrolled and disorderly fragmentation of the eurozone and the euro. Already, the hard-earned credibility of some key regional institutions has been exposed to excessive risk, including the European Central Bank, which is central to the longer-term well being of Europe.

Most political visionaries would opt for the first approach -- doing whatever it takes to maintain the current zone, and do so for as long as it takes. But there should be no doubts here. This is a very expensive proposition that involves widespread, multi-year cross-guarantees and subsidization. Yet it entails significant uncertainties, given that certain peripheral economies face not just a big debt crisis but also a deep-rooted growth crisis.

Indeed, many economists would caution core European countries on such a big challenge. After all, the underlying problems go well beyond political disputes. They also involve difficult design and engineering challenges.

Economists rightly point out that, under this first approach, the core economies could use their stronger balance sheet to assume the debt of the weak peripherals but, critically, there is little they can do to enable them to grow properly. With such considerable open-ended exposure, this is an expensive and risky path, both upfront and over time.

This path should only be pursued if core countries have more than "assurances" that the weak peripheral economies are both able and willing to fundamentally change their economic governance, institutions and behavior. There must also be credible pre-commitment mechanisms. Unfortunately, these are very difficult to implement. Moreover, the social appetite for adjustment in some peripheral economies is understandably near exhaustion, complicated by the wrong perception that austerity is being "imposed" by "rich" neighbors.

The alternative is for Europe to bite the bullet and opt for a smaller but stronger zone. Certain weak peripheral economies (Greece and, possibly, 1-2 others but, importantly, not Italy) would restructure their debt and take a sabbatical from the euro. In doing so, they would gain greater domestic policy flexibility to deal with both their debt and growth crises. Meanwhile, the remaining members of the zone would be able to proceed more rapidly towards a more complete and stronger economic union.

This second path also involves significant costs and risks, especially given the high likelihood of upfront disruptions. Remember, there are no mechanisms for an orderly exit from the zone. Trade flows would be dislocated for a while. Also, it would become obvious that certain European banks face both capital shortfalls and asset quality problems. And, to add to the uncertainties, contagion winds would blow throughout the smaller zone.

Yes, pursuing a smaller but stronger zone involves risks and costs, too. This is part of Europe's unfortunate reality: At this stage, there are no easy and costless options to solve the region's growing turmoil. Fortunately, this second approach has an important benefit, both in absolute terms and relative to other alternatives: it can put the zone on a firmer longer-term footing.

Making this difficult choice would ensure that the underlying resilience and soundness of Europe, which are still considerable, are preserved and enhanced for many future generations. There is little time to waste.